Financial Development and Amplification

Abstract

Does financial development exacerbate or dampen financial amplification? This paper develops a macroeconomic model with the borrowing constraint and heterogeneous agents to answer this question. In our framework, financial development produces two competing forces. One is the effect which accelerates amplification by strengthening balance sheet effects. The other is the effect which reduces it, we call shock cushioning effects. Whether financial development exacerbates or dampens amplification depends on the balance of two effects. We find that the relation between financial development and amplification is non-monotone: amplification initially increases with financial development and later falls down.

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